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Chapter IX

External Auditors’ Roles and
      Responsibilities
Chapter Objectives:
• Recognize the role independent auditors play in achieving effective corporate
governance and reliable financial reports.

• Understand the history of auditing, the traditional roles of auditors, and regulations
recently placed on them.

• Address the expectation gap regarding what auditors can provide in the way of
reasonable assurance and the expectations of investors for a higher level of
assurance.

• Identify the roles and responsibilities of the PCAOB, and discuss the auditing
standards published by the PCAOB.

• Demonstrate the importance of auditor independence both in fact and in appearance.

• Discuss an integrated audit of both financial statements and ICFR.

• Address the issue of a liability cap for independent auditors, and understand the
rationale on both sides of the issue.

                                    VIDEO ( VIDEO)
Key Terms
The Accountancy Investigation & Discipline Board (AIDB)
Audit quality
Audit risk
Audit strategy
Auditor independence
Control risk
Detection risk
Expectation gap
Inherent risk
Integrated audit approach
Internal Revenue Service (IRS)
International Standards on Auditing (ISAs)
PCAOB-US
Professional Ethics Executive
Committee (PEEC)
Standing Advisory Group (SAG)
Statements on Auditing Standards
External Auditing and Corporate
          Governance
External Auditor Responsibility
Current auditing standards require that independent auditors
provide reasonable assurance that the financial statements
are free from material misstatements, whether caused by
error or fraud, to render an unqualified opinion on the financial
statements.

External auditors are not and should not be expected to
provide absolute assurance regarding reliability of financial
statements, but the public expectations concerning external
auditors performance are high.

Users of audited financial statements generally expect
external auditors to detect financial statement fraud and
employees’ illegal acts and fraud, which affects the integrity
of financial reports. External auditors, however, are more
concerned with material misstatements in the audited
financial statements.
Auditor Competency
1. Professional competencies. To audit public companies,
   auditors should register with the PCAOB and meet all
   registration and inspection requirements.
2. Technical competencies. Auditors should be knowledgeable
   in professional standards, rules, laws and regulations, and
   understand their clients’ industry and business, corporate
   governance, financial reporting process, and internal
   controls.
3. Process competencies. Auditor’s ability to choose
   appropriate evidence-gathering procedures (tests of
   controls,   substantive    tests)  and    execute   auditing
   procedures
4. Reporting competencies. Reporting competencies refer to
   the auditors’ ability and willingness to discover and report
   material misstatements.
Reports Accompanying
Financial Statements
 • Report on financial statements and related disclosures
   (prepared by auditor)
     Are financial statements and disclosures according to GAAP?
 • Report on internal control over financial reporting
   (prepared by management)
     Has company maintained effective internal control over financial
      reporting?
 • Report on internal control over financial reporting
   (prepared by auditor)
     Is management’s assessment of its internal control appropriate?
     Has company maintained effective internal control over financial
      reporting?
The Purpose of the Audit Report
• Definition of auditing: “... communicating results to
  interested users.”
• Indicate whether the FS are in accordance with GAAP
    Provide indication of what the FS would be like if GAAP were
     followed
    Provide any company-omitted disclosures
• Indicate any unusual aspects of the audit examination
    Scope limitations
    Division of responsibility
• Indicate any unusual matters related to the company
    Going concern uncertainty
    Consistency
    Emphasize a matter
Four Categories of
Audit Reports
• Standard unqualified (clean opinion)

• Unqualified with explanatory paragraph or
  modified wording

• Qualified

• Adverse or disclaimer
Definitions: Webster’s New
 Unabridged Dictionary
• Qualified:
   Having met conditions or requirements set
   Limited, modified
• Unqualified:
   Not having the usual or requisite talents,
    abilities, or accomplishments
   Not modified, limited, or restricted by conditions
    or exceptions
Types of Audit Reports
Type of Report                          Interpretation
Unqualified         Financial statements taken as a whole present fairly
Opinion             the financial position, results of operations, and cash
                    flows in conformity with generally accepted
                    accounting principles (GAAP).
Qualified Opinion   ―Except for‖ the effects of a particular matter, the
                    financial statements present fairly the financial
                    position, results of operations, and cash flows in
                    conformity with GAAP.
Adverse Opinion     Financial statements do not present fairly the financial
                    position, results of operations, and cash flows in
                    conformity with GAAP.
Disclaimer of       Auditor does not express an opinion on the financial
Opinion             position, results of operations, or cash flows.
Unqualified Reports
Standard Unqualified Report
The five necessary conditions have been met:
   1. All four required statements are included.
   2. The three general standards have been
      followed in all respects on the engagement.
   3. Sufficient evidence has been accumulated
      and the auditor has conducted the
      engagement in a manner that enables the
      conclusion that the three standards of field
      work have been met.
Standard Unqualified Report
  4. The financial statements are presented in
     accordance with GAAP (including adequate
     disclosures.
  5. There are no circumstances requiring the
     addition of an explanatory paragraph or
     modification of the report wording.
Standard Unqualified Audit Report
   (Nonlisted Companies)
Title            Report of Independent Auditor

Address     To the Board of Directors and stockholders of Any
to client   company

Audit       AuditWe have audited the accompanying balance
notice      notice of Any company as of December 31, 1990
            sheets
            and 1989, and the related statements of income,
Identify                                                        Management
            retained earnings, and cash flows for the year
the                                                             responsibility
            then ended. These financial statements are the
financial   responsibility of the company’s management. Our
statement   responsibility is to express an opinion on these    Auditor
s           financial statements based on our audits.           responsibility


                           continued
We conducted our audits in accordance with
             generally accepted auditing standards. Those
             standards require that we plan and perform the
             audit to obtain reasonable assurance about
             whether the financial statements are free of
             material misstatement. An audit includes
Descriptio   examining, on a test basis, evidence supporting
n of the     the amounts and disclosures in the financial
audit        statements. An audit also includes assessing the
             accounting principles used and significant
             estimates made by management, as well as
             evaluating the overall financial statement
No special   presentation. We believe that our audit provides a   Opinion on
                  In our opinion, the financial statements
mention of   reasonableabove for our opinion. all material
             referred to basis present fairly, in                 financial
adequate                                                          statement
             respects, the financial position of Any company as
disclosure                                                        s
             of December 31, 1990 and 1989, and the results
or
             of its operations and its cash flows for the years   Refer to
consistenc
             then ended in conformity with generally accepted     GAAP
y
             accounting principles.
Signature     ___________________________________,
              CPA
Date                                   February 28, 1991
Audit Failures and Audit Quality
Following is the list of the initiatives that have been
suggested to improve audit quality, as well as transparency.

1. Publication of audit engagement letters
2. Shareholders’ rights to question auditors
3. Publication of auditor resignation statements
4. Lead audit partner’s signature on audit reports
5. Active audit committee participation in evaluating the
   scope and results of the integrated audit of both ICFR and
   financial statements
6. Mandatory rotation of the audit firm every seven to twelve
   years in the context of the quality of audit work performed
   by the firm and the audit efficacy
7. Mandatory shareholder vote on the ratification of the
   independent auditor each year
Public Company Accounting
         Oversight Board
The PCAOB              created by SOX to regulate the auditing
profession.

The PCAOB’s primary functions are to:

1. Register public accounting firms that audit public
companies.
2. Inspect the registered public accounting firms on a regular
basis.
3. Establish auditing, attestation, ethics, quality control, and
independence standards.
4. Conduct investigations and disciplinary proceedings.
PCAOB Auditing Standards
The PCAOB has issued five auditing           standards as of
September 2007:

1. PCAOB Auditing Standard No. 1 (audit is conducted in
accordance with auditing standards of PCAOBUS, the city and
state has to be disclosed)
2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No.
5 superseded AS No. 2 and requires the independent audit to
opine only on the effectiveness of ICFR, not the management
processes and assessments concerning ICFR)
3. PCAOB Auditing Standard No. 3 (auditors are required to
maintain the audit documentation in a sufficient manner and
keep the records for at least seven years)
4. PCAOB Auditing Standard No. 4 (voluntary engagement for
the auditor’s report on the company’s elimination of previously
reported material weaknesses in its ICFR)
Roles and Responsibilities—Internal Control over
Financial Reporting
• Management: Designs and implements the system of
  internal control over financial reporting; evaluates the
  effectiveness of the company’s internal control over financial
  reporting and provides a public report on that assessment;
  prepares the financial statements.
• Audit Committee: Has responsibility for oversight of the
  company’s financial reporting process.
• Independent Auditor: Performs an audit of internal control
  over financial reporting and issues a report on
  management’s assessment of internal control over financial
  reporting and on the effectiveness of internal control over
  financial reporting; also performs an audit of the company’s
  financial statements.
                                                             20
What Management’s Report
Will Include
Under the SEC rules, management’s report on internal control over
  financial reporting should include the following information:
• Statement of management’s responsibility for establishing and
  maintaining adequate internal control over financial reporting.
• Statement identifying the framework used by management to evaluate
  the effectiveness of internal control over financial reporting.
• Management’s assessment of the effectiveness of the company’s
  internal control over financial reporting as of the end of the company’s
  most recent fiscal year, including an explicit statement as to whether that
  control is effective and disclosing any material weakness identified by
  management in that control.
• Statement that the registered public accounting firm that audited the
  financial statements included in the annual report has issued an
  attestation report on management’s internal control assessment.



                                                                         21
PCAOB Auditing Standard No. 2:
An Audit of Internal Control over Financial Reporting Performed in Conjunction with
an Audit of Financial Statements



    1. AS No. 2 required three integrated reports on:
         a. Financial statements audited by registered public accounting
            firms.
         b. Management’s assessment of the effectiveness of internal
            control over financial reporting (Section 404).
         c. The effectiveness of internal control over financial reporting
            over financial reporting based on the auditor’s attestation of
            internal control.
    2. AS No. 2 was effective beginning June 17, 2004.


                                                                             22
The Independent Auditor’s Opinion
The content of the auditor’s report is prescribed by the
  PCAOB standard. The most common opinions on the
  effectiveness of internal control over financial reporting will
  be:
• Unqualified Opinion. An opinion that internal control over
  financial reporting is effective: no material weaknesses in
  internal control over financial reporting exist as of the fiscal
  year-end assessment date.
• Adverse Opinion. An opinion that internal control over
  financial reporting is not effective: one or more material
  weaknesses exist as of the fiscal year-end assessment
  date.
• Disclaimer of Opinion. A report stating that restrictions on
  the scope of the auditor’s work prevent the auditor from
  expressing an opinion on the company’s internal control
  over financial reporting.
                                                                23
Report of Independent Registered Public
                       Accounting Firm
                  1. Introductory                                    2. Scope                                       3. Definition
                  Paragraph                                          Paragraph                                      Paragraph




                   6. Inherent                                    5. Explanatory                                    4. Opinion
                   Limitations                                    Paragraph*                                        Paragraph
                   Paragraph




                  7. Signature                                       8. City and                                    9. Date
                                                                     State or
                                                                     County

*The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraph
when the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on the
financial statement audit in the report on the internal control audit.

                                                                                                                                              24
25
Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.   26
Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.   27
PCAOB Auditors Independence

The new rules restrict public accounting firms in
performing a variety of tax services to their audit clients.
The new rules are intended to prevent the selling of
abusive tax shelters.
Audit Committee Oversight of
           External Auditors
The extended     oversight   responsibilities   for   the   audit
committee are:

1. Appointment, compensation, and retention of registered
public accounting firms
2. Preapproval of audit services and permissible nonaudit
services
3. Review of the independent auditor’s plan for an integrated
audit of both ICFR and annual financial statements
4. Review and discussion of financial statements audited or
reviewed by the independent auditor
5. Monitoring the auditor’s independence
6. Auditor rotation requirement
Audit Committee Oversight of
       External Auditors

The number of companies that change auditors, and the
            number of auditors changed
Independent Auditors
Communications with the Audit
        Committee
Communications from the committee to the                 Communications from the independent
independent auditor:                                     auditor to the audit committee:

1. Appointment and retention approval of the             1. Seeking committee preapproval of all audit and
    independent auditor                                  nonaudit services in a timely manner
2. Formal approval of audit and permissible nonaudit     2. The critical accounting policies and practices used by
services                                                 management in the preparation of financial statements
3. Formal approval of fees for both audit and nonaudit   3. All alternative treatments of financial information within
services with a keen focus on improving the quality of   GAAP
audit and nonaudit services                              4. Any accounting disagreements between the
4. Any concerns or risks threatening management’s        independent auditor and the company’s management
reputation and integrity, etc.                           5. Any material, written communications between the
5. Allegations of financial statement fraud              independent auditor and the company’s management
                                                         throughout the course of the audit
                                                         6. Significant deficiencies and material weaknesses of
                                                         ICFR
                                                         7. The audit report on annual financial statements
                                                         8. The review report on quarterly financial statements
                                                         9. The audit report on management’s assessment of the
                                                         effectiveness of ICFR
                                                         10. The audit report on the effectiveness of ICFR
                                                         11. Financial risks associated with financial reports
Auditor Independence

    Auditor Independence
Consolidation and Competition
 in Public Accounting Firms
SEC rules require public companies that change their public
accounting firms to file a Form 8-K, Item 4.01, to disclose
changes within four days, whereas auditors are required to
provide standard letters within ten days stating whether they
agree with the company’s disclosure without specifying any
reasons.
Integrated Audit Approach


            Management assessment on
             the effectiveness of ICFR


            Effectiveness of both design
            and operation of ICFR based
                 on control criteria

           Fair presentation of financial
           statements in conformity with
                      GAAP
Audit Strategy
Audit Strategy:

1. No limited tests of controls
2. No use of cycle rotation in tests of controls
3. Dual testing of controls and substantive audit procedures



Auditors should focus on prevention, detection, and correction
of controls at both the company level and the transaction
level. Auditors should perform tests of controls as a basis for
forming an opinion on the effectiveness of ICFR. Auditors
should also perform substantive tests as a basis for
expressing an opinion on the fair presentation of financial
statements,     regardless   of  the    identified  significant
deficiencies and material weaknesses in internal controls.
The Audit




            Video
Brief History Fraud Investigation
 • 1900s -- Fraud detection was a primary
   objective of the audit
 • 1940s -- Detection of fraud considered to be
   a ―responsibility not assumed‖
 • 1960s -- Auditor acknowledged responsibility
   for detecting fraud that would normally be
   uncovered by an examination performed in
   accordance with GAAS.
 • 1980s -- Auditor had responsibility to search
   for fraud that may have a material affect on
   the financial statements.
 • 1997 -- SAS No. 82; 2002 – SAS No. 99
                                         37
Types of Fraud         Financial Statement Fraud
                       Misrepresentation of material
                       facts
                       Misappropriation of assets

                       Concealment of material
                       facts
          Management
            Fraud
                       Illegal Acts
                       Bribery
                       Conflict of Interest

                       Embezzlement of money or
  FRAUD                property
                        Breach of fiduciary duty

                       Theft of trade secrets of
           Employee    intellectual property
            Fraud
                        Illegal acts
Why People Commit Fraud
Studies show that employees are likely to
  commit fraud when four conditions exist:
     – PRESSING FINANCIAL NEED
     – OPPORTUNITY
     – REASONABLE JUSTIFICATION
     – LACK OF MORAL PRINCIPLES




                                     39
Embezzlement Formula

MOTIVE            +
OPPORTUNITY       +
RATIONALIZATION   =
CRIME [FRAUD]



                      40
Profile of Fraud Perpetrators
The fraud perpetrator is more likely to be an ordinary member of the
community: intelligent, respected, never suspected of dishonesty,
NOT YOUR TYPICAL CRIMINAL TYPE.

MORE LIKELY TO BE:                   LESS LIKELY TO BE:
• A woman                            • Divorced
• Married                            • Alcoholic
• Church member                      • Tattooed
• Older
• Heavier
• Have children
• Have a higher education
• Never been arrested
• Have high self-esteem
• High achiever
                                                         41
Financial Statement Fraud
• Definition – Deliberate misstatements or omissions
  of amounts or disclosures of financial statements to
  deceive financial statement users, particularly
  investors and creditors
• Financial statement fraud has become a daily thing.
  Press reports challenge the corporate responsibility
  and integrity of major companies such as Lucent,
  Xerox, Rite-Aid, Waste Management,
  Microstrategy, KnowledgeWare, Sunbeam,
  Cendent, and ZZZ Best, Enron, WorldCom, Qwest,
  Madoff, Satyam, Stanford Financial, and Parmalat.

                                           42
High-Profile Financial statement
               Fraud
Basis of the Fraud              Older Example      Year   Recent Example   Year


Fictitious revenue,             ZZZZ Best                 Enron
documentation forgery and                          1987                    2001
theft of corporate assets

Personal use of assets, false   Phar-Mor           1992   Adelphia         2002
documentation and financial
statement fraud

Capitalizing expenses, among Waste                 1997   WorldCom         2002
other issues                 Management


Abuse of accounting             Savings and Loan   1982   Stock Options
standards                       Crisis                    Backdating       2006
Symptoms of Financial
        Statement Fraud
• Continuous Deterioration of Quality and
  Quantity of Earnings
• Inadequacy of Cash Flow
• Overstatement of Inventories
• Overly Aggressive Accounting
• Management ―Short-termism‖
• Improper Revenue Recognition
• Overstatement of Assets
Elements of Fraud
• A false representation of a material nature
• Knowledge that the representation is false or
  reckless disregard for the truth (Scienter)
• Reliance on the false representation by the
  victim
• Financial damages are incurred (to the
  benefit of the perpetrator).
• The act was intentional.
Auditor and Investigator
                  Responsibilities
• External Auditors (CPAs)
    SAS 99: Consideration of Fraud in a Financial Statement Audit
       – Design audit to provide reasonable assurance of detecting fraud that could have
         a material effect on the financial statements.
       – Perform fraud-related procedures
    SAS 54: Illegal Acts
       – Focused primarily is on direct-effect illegal acts
    SAS 61: Communication with Audit Committees
• Internal Auditors (CIAs)
    SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud
• Governmental Auditors
    Focus on laws and regulations (compliance), design audit to detect abuse
     and illegal acts, report to the appropriate authority
• Certified Fraud Examiners (CFEs)
    Assignments begin with predication (probable cause)


                                                                       46
Auditor’s Responsibility for
         Detecting Fraud
• GAAS makes NO DISTINCTION
  between the auditor’s responsibilities for
  searching for errors or for fraud

• Per SAS No. 99, auditors must
  specifically assess the risk of material
  misstatement due to fraud


                                      47
Assessing the Risk of Fraud
• Pressure or incentive to commit the fraud
   Direct financial gain, such as misappropriation
    of assets or retaining job
   Indirect financial gain, such as increase in
    stock price
• Perceived opportunity to commit the fraud
   Can fraud be perpetrated without detection?


                                          48
Misappropriation of Assets
             Risk Factors
• Susceptibility of assets
  to misappropriation
• Employee relationships
  or pressures
• Deficiencies in internal
  control

                              49
Red Flags
• Personal financial pressure
• Vices (drugs, alcohol or gambling)
• Extravagant lifestyles
• Real or imagined grievances against
  company
• Related parties
• Increased stress
• Internal pressures
                                50
How Frauds Occurred
• Poor internal controls
• Management override of internal controls
• Collusion between employees and third
  parties
• Collusion between employees or
  management
• Lack of control over management
• Poor or nonexistent corporate ethics policy
                                    51
Reasons Auditors Fail to Detect Fraud
• Over reliance on client representations
• Lack of awareness or failure to recognize
  that an observed condition may indicate a
  material fraud
• Lack of experience
• Personal relationships with clients



                                     52
SAS No. 99

       The Fraud Triangle

          Rationalization


Incentives/             Opportunities
Pressures

                                53
The Fraud Triangle
• Incentives/Pressures
   95 percent of all fraud cases involve either:
     – Financial pressures
     – Vice-related pressures, including drug or alcohol
       addiction
     – Expensive romantic relationships
     – Need to maintain a particular lifestyle
     – Medical problems



                                                 54
The Fraud Triangle
• Rationalization is the reconciliation
  of what we are doing with what our
  conscience tells us we should do.
• "I was only borrowing it;
  I planned to return it after things
  improved."



                                        55
The Fraud Triangle
• Opportunity
   Easiest to control of the three components
   Most frequently achieved with internal
    controls
    – Segregation of duties
    – Authorizations
    – Independent checks
    – Physical safeguards
    – Adequate documents and records
                                       56
3Cs of Financial statement Fraud
Evaluate Control
                                                                                    Environment


                                                                                  Tests of Controls


   Audit            Inherent Risk                     X            Control Risk                       X
                =                                                                                                Detection Risk
   Risk


                                         Errors                                        Errors                          Errors         Analytical
                                                                                                                                     Procedures


                    Misappropriation                               Misappropriation                               Misappropriation    Tests of
                       of Assets                                      of Assets                                      of Assets        Details

                                                   Financial                                     Financial
                                                  Statement                                     Statement
                                                                                                                      Financial
                                                     Fraud                                         Fraud                              Forensic
                                                                                                                     Statement
                                                                                                                        Fraud        Procedures

                                                                           Evaluate
                                     Management                                                   Evaluate Top
                                                                         Controls Over
                                      Integrity                                                   Management
                                                                            Assets
                                                                                                    Controls
                       R                                       R
                       1                                       2
   Incentive/                                                      Opportunity
    Pressure


  Incentive/                           Attitude/                    Opportunity
Pressure Fraud                      Rationalization                 Fraud Risk
 Risk Factors                         Fraud Risk                      Factors
                                        Factors




                                                                                                                         58
Audit of Defined Benefit
              Pensions
Employer-defined benefit pension reforms, as proposed by the
administration and introduced by both the House and the
Senate, would require plan sponsors to make minimum funding
contributions equal to the greater of:
(1)the contributions required under the plan’s funding standard
   account estimated based on the plan’s actuarial accrued
   liability,
(2)deficient reduction contributions calculated under current
   liability rules.

These reforms would replace the current law’s “double-barrel”
system with a single measure of assets and liabilities and
required funding method.
Auditors’ Liability Limitation
              Agreement
In February 2006, the Federal Financial Regulatory Agencies
issued an interagency advisory that raised concerns regarding
the negative impacts on the quality and reliability
of audits when financial institutions agree to limit their
independent auditors’ liability.

The advisory, while observing an increase in the types and
extent of provisions in financial institutions’ external audit
engagement letters that limit auditor liability, informs
financial institutions that they should not enter into an audit
engagement that includes unsafe and unsound limitation of
liability provisions relevant to an integrated audit of their
financial statements and ICFR.
Auditors Liability Limitation
        Agreement
Conclusion
• The audit function should be regarded as an external corporate
governance mechanism that serves to protect investors from
receiving incomplete, inaccurate, or misleading financial information
and thus adds value to the effectiveness of corporate governance.
• SOX drastically changed the characteristics of the accounting
profession by connecting the audit function to the corporate
governance structure by requiring that the audit committee be directly
responsible for not only hiring, compensating, and firing external
auditors, but also overseeing their work, monitoring their
independence, and avoiding potential conflicts of interest.
• In the auditing profession, the so-called expectation gap is referred
to as the difference between (1) what the investing public and other
users of audited financial statements believe the responsibilities of
auditors are, and (2) what auditors are willing to assume as
responsibilities according to their professional standards.
• New PCAOB AS No. 5 superseded AS No. 2 and requires the
independent audit to opine only on the effectiveness of ICFR, not the
management processes and assessments concerning ICFR.
Conclusion
• Sections 201 and 202 of SOX require that all audit and permissible
nonaudit services to be performed by the company’s independent
auditor be approved by the audit committee.
• Auditor independence is the backbone of the auditing profession,
affecting the auditor’s planning, evidence-gathering procedures,
findings, judgment, and credibility, and public trust in the auditor’s
opinion.
• Auditor independence is derived and guided by these three
principles: (1) independent auditors may not audit their own work, (2)
independent auditors may not function in the role of their client’s
management, and (3) independent auditors may not serve in an
advocacy role for their audit clients.
• Tests of controls must be broadened to include understanding of
ICFR and provide reasonable assurance about the effectiveness of
both the design and operation of internal controls.
• Any contractual provisions that limit the external auditor’s liability or
require waiving the right to a jury trial may have detrimental effects
on auditor impartiality, objectivity, and quality.

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Presentation chapter 9

  • 1. Chapter IX External Auditors’ Roles and Responsibilities
  • 2. Chapter Objectives: • Recognize the role independent auditors play in achieving effective corporate governance and reliable financial reports. • Understand the history of auditing, the traditional roles of auditors, and regulations recently placed on them. • Address the expectation gap regarding what auditors can provide in the way of reasonable assurance and the expectations of investors for a higher level of assurance. • Identify the roles and responsibilities of the PCAOB, and discuss the auditing standards published by the PCAOB. • Demonstrate the importance of auditor independence both in fact and in appearance. • Discuss an integrated audit of both financial statements and ICFR. • Address the issue of a liability cap for independent auditors, and understand the rationale on both sides of the issue. VIDEO ( VIDEO)
  • 3. Key Terms The Accountancy Investigation & Discipline Board (AIDB) Audit quality Audit risk Audit strategy Auditor independence Control risk Detection risk Expectation gap Inherent risk Integrated audit approach Internal Revenue Service (IRS) International Standards on Auditing (ISAs) PCAOB-US Professional Ethics Executive Committee (PEEC) Standing Advisory Group (SAG) Statements on Auditing Standards
  • 4. External Auditing and Corporate Governance
  • 5. External Auditor Responsibility Current auditing standards require that independent auditors provide reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud, to render an unqualified opinion on the financial statements. External auditors are not and should not be expected to provide absolute assurance regarding reliability of financial statements, but the public expectations concerning external auditors performance are high. Users of audited financial statements generally expect external auditors to detect financial statement fraud and employees’ illegal acts and fraud, which affects the integrity of financial reports. External auditors, however, are more concerned with material misstatements in the audited financial statements.
  • 6. Auditor Competency 1. Professional competencies. To audit public companies, auditors should register with the PCAOB and meet all registration and inspection requirements. 2. Technical competencies. Auditors should be knowledgeable in professional standards, rules, laws and regulations, and understand their clients’ industry and business, corporate governance, financial reporting process, and internal controls. 3. Process competencies. Auditor’s ability to choose appropriate evidence-gathering procedures (tests of controls, substantive tests) and execute auditing procedures 4. Reporting competencies. Reporting competencies refer to the auditors’ ability and willingness to discover and report material misstatements.
  • 7. Reports Accompanying Financial Statements • Report on financial statements and related disclosures (prepared by auditor)  Are financial statements and disclosures according to GAAP? • Report on internal control over financial reporting (prepared by management)  Has company maintained effective internal control over financial reporting? • Report on internal control over financial reporting (prepared by auditor)  Is management’s assessment of its internal control appropriate?  Has company maintained effective internal control over financial reporting?
  • 8. The Purpose of the Audit Report • Definition of auditing: “... communicating results to interested users.” • Indicate whether the FS are in accordance with GAAP  Provide indication of what the FS would be like if GAAP were followed  Provide any company-omitted disclosures • Indicate any unusual aspects of the audit examination  Scope limitations  Division of responsibility • Indicate any unusual matters related to the company  Going concern uncertainty  Consistency  Emphasize a matter
  • 9. Four Categories of Audit Reports • Standard unqualified (clean opinion) • Unqualified with explanatory paragraph or modified wording • Qualified • Adverse or disclaimer
  • 10. Definitions: Webster’s New Unabridged Dictionary • Qualified:  Having met conditions or requirements set  Limited, modified • Unqualified:  Not having the usual or requisite talents, abilities, or accomplishments  Not modified, limited, or restricted by conditions or exceptions
  • 11. Types of Audit Reports Type of Report Interpretation Unqualified Financial statements taken as a whole present fairly Opinion the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (GAAP). Qualified Opinion ―Except for‖ the effects of a particular matter, the financial statements present fairly the financial position, results of operations, and cash flows in conformity with GAAP. Adverse Opinion Financial statements do not present fairly the financial position, results of operations, and cash flows in conformity with GAAP. Disclaimer of Auditor does not express an opinion on the financial Opinion position, results of operations, or cash flows.
  • 13. Standard Unqualified Report The five necessary conditions have been met: 1. All four required statements are included. 2. The three general standards have been followed in all respects on the engagement. 3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables the conclusion that the three standards of field work have been met.
  • 14. Standard Unqualified Report 4. The financial statements are presented in accordance with GAAP (including adequate disclosures. 5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the report wording.
  • 15. Standard Unqualified Audit Report (Nonlisted Companies) Title Report of Independent Auditor Address To the Board of Directors and stockholders of Any to client company Audit AuditWe have audited the accompanying balance notice notice of Any company as of December 31, 1990 sheets and 1989, and the related statements of income, Identify Management retained earnings, and cash flows for the year the responsibility then ended. These financial statements are the financial responsibility of the company’s management. Our statement responsibility is to express an opinion on these Auditor s financial statements based on our audits. responsibility continued
  • 16. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes Descriptio examining, on a test basis, evidence supporting n of the the amounts and disclosures in the financial audit statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement No special presentation. We believe that our audit provides a Opinion on In our opinion, the financial statements mention of reasonableabove for our opinion. all material referred to basis present fairly, in financial adequate statement respects, the financial position of Any company as disclosure s of December 31, 1990 and 1989, and the results or of its operations and its cash flows for the years Refer to consistenc then ended in conformity with generally accepted GAAP y accounting principles. Signature ___________________________________, CPA Date February 28, 1991
  • 17. Audit Failures and Audit Quality Following is the list of the initiatives that have been suggested to improve audit quality, as well as transparency. 1. Publication of audit engagement letters 2. Shareholders’ rights to question auditors 3. Publication of auditor resignation statements 4. Lead audit partner’s signature on audit reports 5. Active audit committee participation in evaluating the scope and results of the integrated audit of both ICFR and financial statements 6. Mandatory rotation of the audit firm every seven to twelve years in the context of the quality of audit work performed by the firm and the audit efficacy 7. Mandatory shareholder vote on the ratification of the independent auditor each year
  • 18. Public Company Accounting Oversight Board The PCAOB created by SOX to regulate the auditing profession. The PCAOB’s primary functions are to: 1. Register public accounting firms that audit public companies. 2. Inspect the registered public accounting firms on a regular basis. 3. Establish auditing, attestation, ethics, quality control, and independence standards. 4. Conduct investigations and disciplinary proceedings.
  • 19. PCAOB Auditing Standards The PCAOB has issued five auditing standards as of September 2007: 1. PCAOB Auditing Standard No. 1 (audit is conducted in accordance with auditing standards of PCAOBUS, the city and state has to be disclosed) 2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR) 3. PCAOB Auditing Standard No. 3 (auditors are required to maintain the audit documentation in a sufficient manner and keep the records for at least seven years) 4. PCAOB Auditing Standard No. 4 (voluntary engagement for the auditor’s report on the company’s elimination of previously reported material weaknesses in its ICFR)
  • 20. Roles and Responsibilities—Internal Control over Financial Reporting • Management: Designs and implements the system of internal control over financial reporting; evaluates the effectiveness of the company’s internal control over financial reporting and provides a public report on that assessment; prepares the financial statements. • Audit Committee: Has responsibility for oversight of the company’s financial reporting process. • Independent Auditor: Performs an audit of internal control over financial reporting and issues a report on management’s assessment of internal control over financial reporting and on the effectiveness of internal control over financial reporting; also performs an audit of the company’s financial statements. 20
  • 21. What Management’s Report Will Include Under the SEC rules, management’s report on internal control over financial reporting should include the following information: • Statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting. • Statement identifying the framework used by management to evaluate the effectiveness of internal control over financial reporting. • Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year, including an explicit statement as to whether that control is effective and disclosing any material weakness identified by management in that control. • Statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s internal control assessment. 21
  • 22. PCAOB Auditing Standard No. 2: An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements 1. AS No. 2 required three integrated reports on: a. Financial statements audited by registered public accounting firms. b. Management’s assessment of the effectiveness of internal control over financial reporting (Section 404). c. The effectiveness of internal control over financial reporting over financial reporting based on the auditor’s attestation of internal control. 2. AS No. 2 was effective beginning June 17, 2004. 22
  • 23. The Independent Auditor’s Opinion The content of the auditor’s report is prescribed by the PCAOB standard. The most common opinions on the effectiveness of internal control over financial reporting will be: • Unqualified Opinion. An opinion that internal control over financial reporting is effective: no material weaknesses in internal control over financial reporting exist as of the fiscal year-end assessment date. • Adverse Opinion. An opinion that internal control over financial reporting is not effective: one or more material weaknesses exist as of the fiscal year-end assessment date. • Disclaimer of Opinion. A report stating that restrictions on the scope of the auditor’s work prevent the auditor from expressing an opinion on the company’s internal control over financial reporting. 23
  • 24. Report of Independent Registered Public Accounting Firm 1. Introductory 2. Scope 3. Definition Paragraph Paragraph Paragraph 6. Inherent 5. Explanatory 4. Opinion Limitations Paragraph* Paragraph Paragraph 7. Signature 8. City and 9. Date State or County *The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraph when the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on the financial statement audit in the report on the internal control audit. 24
  • 25. 25 Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
  • 26. Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org. 26
  • 27. Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org. 27
  • 28. PCAOB Auditors Independence The new rules restrict public accounting firms in performing a variety of tax services to their audit clients. The new rules are intended to prevent the selling of abusive tax shelters.
  • 29. Audit Committee Oversight of External Auditors The extended oversight responsibilities for the audit committee are: 1. Appointment, compensation, and retention of registered public accounting firms 2. Preapproval of audit services and permissible nonaudit services 3. Review of the independent auditor’s plan for an integrated audit of both ICFR and annual financial statements 4. Review and discussion of financial statements audited or reviewed by the independent auditor 5. Monitoring the auditor’s independence 6. Auditor rotation requirement
  • 30. Audit Committee Oversight of External Auditors The number of companies that change auditors, and the number of auditors changed
  • 31. Independent Auditors Communications with the Audit Committee Communications from the committee to the Communications from the independent independent auditor: auditor to the audit committee: 1. Appointment and retention approval of the 1. Seeking committee preapproval of all audit and independent auditor nonaudit services in a timely manner 2. Formal approval of audit and permissible nonaudit 2. The critical accounting policies and practices used by services management in the preparation of financial statements 3. Formal approval of fees for both audit and nonaudit 3. All alternative treatments of financial information within services with a keen focus on improving the quality of GAAP audit and nonaudit services 4. Any accounting disagreements between the 4. Any concerns or risks threatening management’s independent auditor and the company’s management reputation and integrity, etc. 5. Any material, written communications between the 5. Allegations of financial statement fraud independent auditor and the company’s management throughout the course of the audit 6. Significant deficiencies and material weaknesses of ICFR 7. The audit report on annual financial statements 8. The review report on quarterly financial statements 9. The audit report on management’s assessment of the effectiveness of ICFR 10. The audit report on the effectiveness of ICFR 11. Financial risks associated with financial reports
  • 32. Auditor Independence Auditor Independence
  • 33. Consolidation and Competition in Public Accounting Firms SEC rules require public companies that change their public accounting firms to file a Form 8-K, Item 4.01, to disclose changes within four days, whereas auditors are required to provide standard letters within ten days stating whether they agree with the company’s disclosure without specifying any reasons.
  • 34. Integrated Audit Approach Management assessment on the effectiveness of ICFR Effectiveness of both design and operation of ICFR based on control criteria Fair presentation of financial statements in conformity with GAAP
  • 35. Audit Strategy Audit Strategy: 1. No limited tests of controls 2. No use of cycle rotation in tests of controls 3. Dual testing of controls and substantive audit procedures Auditors should focus on prevention, detection, and correction of controls at both the company level and the transaction level. Auditors should perform tests of controls as a basis for forming an opinion on the effectiveness of ICFR. Auditors should also perform substantive tests as a basis for expressing an opinion on the fair presentation of financial statements, regardless of the identified significant deficiencies and material weaknesses in internal controls.
  • 36. The Audit Video
  • 37. Brief History Fraud Investigation • 1900s -- Fraud detection was a primary objective of the audit • 1940s -- Detection of fraud considered to be a ―responsibility not assumed‖ • 1960s -- Auditor acknowledged responsibility for detecting fraud that would normally be uncovered by an examination performed in accordance with GAAS. • 1980s -- Auditor had responsibility to search for fraud that may have a material affect on the financial statements. • 1997 -- SAS No. 82; 2002 – SAS No. 99 37
  • 38. Types of Fraud Financial Statement Fraud Misrepresentation of material facts Misappropriation of assets Concealment of material facts Management Fraud Illegal Acts Bribery Conflict of Interest Embezzlement of money or FRAUD property Breach of fiduciary duty Theft of trade secrets of Employee intellectual property Fraud Illegal acts
  • 39. Why People Commit Fraud Studies show that employees are likely to commit fraud when four conditions exist: – PRESSING FINANCIAL NEED – OPPORTUNITY – REASONABLE JUSTIFICATION – LACK OF MORAL PRINCIPLES 39
  • 40. Embezzlement Formula MOTIVE + OPPORTUNITY + RATIONALIZATION = CRIME [FRAUD] 40
  • 41. Profile of Fraud Perpetrators The fraud perpetrator is more likely to be an ordinary member of the community: intelligent, respected, never suspected of dishonesty, NOT YOUR TYPICAL CRIMINAL TYPE. MORE LIKELY TO BE: LESS LIKELY TO BE: • A woman • Divorced • Married • Alcoholic • Church member • Tattooed • Older • Heavier • Have children • Have a higher education • Never been arrested • Have high self-esteem • High achiever 41
  • 42. Financial Statement Fraud • Definition – Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors • Financial statement fraud has become a daily thing. Press reports challenge the corporate responsibility and integrity of major companies such as Lucent, Xerox, Rite-Aid, Waste Management, Microstrategy, KnowledgeWare, Sunbeam, Cendent, and ZZZ Best, Enron, WorldCom, Qwest, Madoff, Satyam, Stanford Financial, and Parmalat. 42
  • 43. High-Profile Financial statement Fraud Basis of the Fraud Older Example Year Recent Example Year Fictitious revenue, ZZZZ Best Enron documentation forgery and 1987 2001 theft of corporate assets Personal use of assets, false Phar-Mor 1992 Adelphia 2002 documentation and financial statement fraud Capitalizing expenses, among Waste 1997 WorldCom 2002 other issues Management Abuse of accounting Savings and Loan 1982 Stock Options standards Crisis Backdating 2006
  • 44. Symptoms of Financial Statement Fraud • Continuous Deterioration of Quality and Quantity of Earnings • Inadequacy of Cash Flow • Overstatement of Inventories • Overly Aggressive Accounting • Management ―Short-termism‖ • Improper Revenue Recognition • Overstatement of Assets
  • 45. Elements of Fraud • A false representation of a material nature • Knowledge that the representation is false or reckless disregard for the truth (Scienter) • Reliance on the false representation by the victim • Financial damages are incurred (to the benefit of the perpetrator). • The act was intentional.
  • 46. Auditor and Investigator Responsibilities • External Auditors (CPAs)  SAS 99: Consideration of Fraud in a Financial Statement Audit – Design audit to provide reasonable assurance of detecting fraud that could have a material effect on the financial statements. – Perform fraud-related procedures  SAS 54: Illegal Acts – Focused primarily is on direct-effect illegal acts  SAS 61: Communication with Audit Committees • Internal Auditors (CIAs)  SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud • Governmental Auditors  Focus on laws and regulations (compliance), design audit to detect abuse and illegal acts, report to the appropriate authority • Certified Fraud Examiners (CFEs)  Assignments begin with predication (probable cause) 46
  • 47. Auditor’s Responsibility for Detecting Fraud • GAAS makes NO DISTINCTION between the auditor’s responsibilities for searching for errors or for fraud • Per SAS No. 99, auditors must specifically assess the risk of material misstatement due to fraud 47
  • 48. Assessing the Risk of Fraud • Pressure or incentive to commit the fraud  Direct financial gain, such as misappropriation of assets or retaining job  Indirect financial gain, such as increase in stock price • Perceived opportunity to commit the fraud  Can fraud be perpetrated without detection? 48
  • 49. Misappropriation of Assets Risk Factors • Susceptibility of assets to misappropriation • Employee relationships or pressures • Deficiencies in internal control 49
  • 50. Red Flags • Personal financial pressure • Vices (drugs, alcohol or gambling) • Extravagant lifestyles • Real or imagined grievances against company • Related parties • Increased stress • Internal pressures 50
  • 51. How Frauds Occurred • Poor internal controls • Management override of internal controls • Collusion between employees and third parties • Collusion between employees or management • Lack of control over management • Poor or nonexistent corporate ethics policy 51
  • 52. Reasons Auditors Fail to Detect Fraud • Over reliance on client representations • Lack of awareness or failure to recognize that an observed condition may indicate a material fraud • Lack of experience • Personal relationships with clients 52
  • 53. SAS No. 99 The Fraud Triangle Rationalization Incentives/ Opportunities Pressures 53
  • 54. The Fraud Triangle • Incentives/Pressures  95 percent of all fraud cases involve either: – Financial pressures – Vice-related pressures, including drug or alcohol addiction – Expensive romantic relationships – Need to maintain a particular lifestyle – Medical problems 54
  • 55. The Fraud Triangle • Rationalization is the reconciliation of what we are doing with what our conscience tells us we should do. • "I was only borrowing it; I planned to return it after things improved." 55
  • 56. The Fraud Triangle • Opportunity  Easiest to control of the three components  Most frequently achieved with internal controls – Segregation of duties – Authorizations – Independent checks – Physical safeguards – Adequate documents and records 56
  • 57. 3Cs of Financial statement Fraud
  • 58. Evaluate Control Environment Tests of Controls Audit Inherent Risk X Control Risk X = Detection Risk Risk Errors Errors Errors Analytical Procedures Misappropriation Misappropriation Misappropriation Tests of of Assets of Assets of Assets Details Financial Financial Statement Statement Financial Fraud Fraud Forensic Statement Fraud Procedures Evaluate Management Evaluate Top Controls Over Integrity Management Assets Controls R R 1 2 Incentive/ Opportunity Pressure Incentive/ Attitude/ Opportunity Pressure Fraud Rationalization Fraud Risk Risk Factors Fraud Risk Factors Factors 58
  • 59. Audit of Defined Benefit Pensions Employer-defined benefit pension reforms, as proposed by the administration and introduced by both the House and the Senate, would require plan sponsors to make minimum funding contributions equal to the greater of: (1)the contributions required under the plan’s funding standard account estimated based on the plan’s actuarial accrued liability, (2)deficient reduction contributions calculated under current liability rules. These reforms would replace the current law’s “double-barrel” system with a single measure of assets and liabilities and required funding method.
  • 60. Auditors’ Liability Limitation Agreement In February 2006, the Federal Financial Regulatory Agencies issued an interagency advisory that raised concerns regarding the negative impacts on the quality and reliability of audits when financial institutions agree to limit their independent auditors’ liability. The advisory, while observing an increase in the types and extent of provisions in financial institutions’ external audit engagement letters that limit auditor liability, informs financial institutions that they should not enter into an audit engagement that includes unsafe and unsound limitation of liability provisions relevant to an integrated audit of their financial statements and ICFR.
  • 62. Conclusion • The audit function should be regarded as an external corporate governance mechanism that serves to protect investors from receiving incomplete, inaccurate, or misleading financial information and thus adds value to the effectiveness of corporate governance. • SOX drastically changed the characteristics of the accounting profession by connecting the audit function to the corporate governance structure by requiring that the audit committee be directly responsible for not only hiring, compensating, and firing external auditors, but also overseeing their work, monitoring their independence, and avoiding potential conflicts of interest. • In the auditing profession, the so-called expectation gap is referred to as the difference between (1) what the investing public and other users of audited financial statements believe the responsibilities of auditors are, and (2) what auditors are willing to assume as responsibilities according to their professional standards. • New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR.
  • 63. Conclusion • Sections 201 and 202 of SOX require that all audit and permissible nonaudit services to be performed by the company’s independent auditor be approved by the audit committee. • Auditor independence is the backbone of the auditing profession, affecting the auditor’s planning, evidence-gathering procedures, findings, judgment, and credibility, and public trust in the auditor’s opinion. • Auditor independence is derived and guided by these three principles: (1) independent auditors may not audit their own work, (2) independent auditors may not function in the role of their client’s management, and (3) independent auditors may not serve in an advocacy role for their audit clients. • Tests of controls must be broadened to include understanding of ICFR and provide reasonable assurance about the effectiveness of both the design and operation of internal controls. • Any contractual provisions that limit the external auditor’s liability or require waiving the right to a jury trial may have detrimental effects on auditor impartiality, objectivity, and quality.